Patent Breadth As An Entry Deterrent: The Case Of Vertically Differentiated Product Innovations

Patents provide very important incentives for innovative activity by enabling innovators to appropriate innovation rents through the granting of exclusive rights on their innovations. The limit of these exclusive rights is defined by two elements - patent length and patent breadth. Patent length is the time period during which the innovator has exclusive rights on the innovation and is predetermined by law. Patent breadth defines the technological territory claimed and protected by the patent - the area in the technological space within which competitors cannot offer rival innovations without infringing the patent - and is explicitly chosen by the innovator. A standard assumption in the economics literature is that an innovator should always choose to claim the maximum patent breadth, thereby deterring the entry of other firms and thus enabling the innovator to earn monopoly rents (see Gilbert and Shapiro and Gallini for examples of this view). Such a strategy, however, fails to recognize that patents are often challenged legally in the Patent Office or in the courts (Cornish). The nature of this challenge is such that the broader is the patent protection, the higher is the probability that the patent will be challenged legally by competitors, that it will overlap another patent and/or that the courts will invalidate it or narrow its scope (Lerner). Given that patent breadth is routinely challenged, the question arises as to whether the innovator is able to choose a patent breadth that deters entry, or whether the innovator is forced to share the market with a new entrant. The purpose of this paper is to examine the optimal patent breadth strategy that an innovator should employ when faced with the possibility that the patent breadth claimed will be challenged. In this paper, the optimal patent strategy is determined in a sequential game of complete information. The agents in the game are an innovator who seeks patent protection and decides on the patent breadth claimed and a potential entrant who decides on whether to enter the patentee's market and, if entry occurs, where to locate in the vertically differentiated product space. The solution to this game is obtained by backward induction - the problem of the entrant is examined first, followed by the problem of the innovator. The paper shows that that it is possible under some conditions for an innovator to use patent breadth to deter entry - when this is possible, the optimal patent strategy is to always deter entry. These conditions occur under certain combinations of the entrant's R&D effectiveness and trial cost values (i.e., low R&D effectiveness - which results in high R&D costs - and high trial costs). When these specific conditions do not hold, the optimal strategy for the innovator is to allow a new competitor to enter the market. When allowing entry, the innovator chooses patent breadth so that the benefits of increased product differentiation that result from greater patent breadth are traded off with the increased likelihood of patent challenge that comes with greater patent breadth. One of the conclusions of the paper is that the innovator will only choose the maximum patent breadth when patent infringement is never an optimal strategy for the entrant. This occurs under a very specific set of conditions (i.e., a combination of very high R&D effectiveness and high trial costs values).